'100 small steps can take us far'

Raghuram Rajan, the first Asian to be appointed as the chief economist of the International Monetary Fund, defends the expert committee's recommendations on a makeover for the financial sector....

Raghuram Rajan shot to fame when he became the first Asian to be appointed as the chief economist of the International Monetary Fund (IMF). He, however, quit the job to return to Chicago's Graduate School of Business where he taught earlier. Last year, the Planning Commission gave him the mandate of working out a roadmap for financial sector reforms in India. In an interview, he defends the expert committee's recommendations on a makeover for the financial sector.

Is this a bad time for the report to be unveiled given the backdrop of a crisis in the global financial markets?

No. First, this report is not meant for the next few months, or even the term of this government, but for the next decade. So its political feasibility has to be seen in that perspective. Second, people are too quick to label any reform proposals as ���deregulation���. If they read the report, they will see we have given a tremendous amount of thought to how to fix regulatory gaps. The recent losses on derivatives transactions suggest all is not well here. Finally, we have a real crisis on our hands, a crisis of access. There are many non-controversial areas where we can move ahead to fix this, where all we need is moderately motivated leadership. A hundred small steps can take us far.

One criticism raised against the committee���s recommendations is that it does not address the ground realities and that there is much that has been said in the past by other committees?

I wish some of those who are quick to comment would actually read the report. For instance, one doyen of the financial sector is quoted in the press as saying: ���It is based on privatising top nationalised banks which is not possible and since most of the report is based on this, the other recommendations also fall flat���. Not only do we recommend against privatising the large public sector banks at this juncture, no recommendations are tied to what we actually do recommend for the large public sector banks.

It is true that in some places we echo what other committees have said, but that is because we think they are right. Even here, we have attempted to find a path that is feasible, from where we are today to where we should be. For instance, our proposals on public sector banks are very practical, informed in many ways by Mr Om Bhatt, chairman of SBI, a committee member who is one of the most energetic reformers I have had the privilege to meet. There is also a tremendous amount of analysis in the report which attempts to convince those with an open mind of what needs to be done. And there are many new proposals that are practical as well as non-controversial, and hence eminently feasible.

There is a suggestion in the report that the central bank should adopt formal inflation target. Comments?

We have recommended the RBI follow an inflation objective, which is not very different from what RBI says it does (it has an objective of 5%). Some people suggest this means we are saying it should not focus on growth. This is nonsense. By focusing on maintaining inflation close to its objective, RBI will also deliver on growth. When the economy is in a bad way (growing below potential), inflation will fall, and RBI can cut rates. The real difference is we are suggesting RBI stop intervening heavily in currency markets, something we believe has limited effects on the exchange rate in the medium run, and risks sparking inflation. Many who advocate continued heavy intervention are living in the past, when such intervention may have worked.

But critics say that central banks, such as Bank of New Zealand, which have an explicit inflation targeting mandates have also been actively intervening.

Central banks intervene, but only on rare occasions when they think the currency may have departed too far from fundamentals. We are not against rare intervention. What we counsel against is an attempt to stand in the way of necessary movement, which comes at great cost to the economy (including through higher inflation and the necessity to hold enormous claims on a depreciating dollar, with the losses masked by the fact we measure our reserves in dollars).

The draft report has proposed opening up the door for foreign banks. How would you justify this when the government and RBI say that there is no reciprocity on this especially when India has gone ahead and granted more licences than it is committed to annually?

RBI has indicated in its roadmap that it wants to grant domestically incorporated foreign banks all the privileges that domestic banks have. We are not going beyond this. But we do recommend freeing up branch licencing for domestic banks. Following the principle of domestic treatment, that privilege should also be extended to foreign banks after a short period (to allow domestic banks to gear up).

The real question is whether we have anything to gain from the foreign banks. I think we have ��� for instance, competitive pressures from foreign banks were a big force in the computerisation of Indian banks, which has benefited us all. Also, even if they are held by foreign shareholders (and the majority stake in some Indian banks is also foreign), many of them are fully staffed in India by Indians, and some have gone on to run the international bank. In our view, India stands to gain from the services provided by foreign banks, especially as it becomes more integrated into the world economy. So while pushing very hard diplomatically on other countries to open their doors to our banks, let us understand that, much as the Indian public has benefited from our unilateral reduction in trade barriers, it will benefit from the services provided by foreign banks.

The report has talked of more play for foreign investment in the local bond markets. RBI has cited its concerns about the risks associated with foreign debt. Are such concerns valid?

One should take a holistic view. If the government borrowed much more in foreign currency, there would be cause to be worried. By contrast, if we allow foreigners into the long term domestic currency markets, as the report proposes, there is far less concern ��� the government will never be forced to default on domestic currency debt (indeed, some label the United States��� ability to borrow from foreigners in its own currency an ���exorbitant privilege���). Also, we free financial institutions to make loans instead of holding government paper. By creating stronger domestic currency corporate bond markets, we reduce the incentive of corporations to borrow through foreign currency ECBs, and thus reduce a source of risk. The committee does, however, recommend such opening up only after we have fixed our monetary policy framework, else we will create one-way bets for foreign investors.

Some countries have moved to a principle-based regulatory approach rather than rule based. Is Indian ready to make that transition in its present stage of financial sector growth?

There are really three broad problems with the Indian regulatory system which, no doubt, has performed creditably so far. It micromanages too much, thus sometimes losing the big picture. There are potentially large regulatory gaps and gaps in responsibility. And is little systematic evaluation of regulatory performance as well as checks on regulatory overreach. These are related.

Micromanagement comes from the statutes. For instance, the requirement that banks obtain regulatory approval for even payment of fees to investment bankers managing equity capital offerings, is enshrined in the Banking Regulation Act. We advocate changing the regulation to focus more broadly on principles, leaving implementation to the regulator. But micromanagement also comes from the incentive structure for regulators. If the CVC or a parliamentary commission can, with the benefit of hindsight, nit pick on every decision made by the regulator, clearly he will have no option but to ensure that every box is ticked. While we need to allow the regulator more freedom to determine regulations, we also need to be more specific about what he will be held responsible for, so that he is not subject to wide-ranging unfocused inquiries. The chapter on regulation offers a number of suggestions on this, and is well worth reading.

The regulatory gaps emerge because our systems for co-ordination like the HLCC are not working effectively, even in the eyes of some regulators, and there are many areas of no, or overlapping, responsibility. The report suggests redrawing the regulatory architecture so that responsibilities are clear (for example, over co-operative banks) but also formalising structures that are in place. A Financial Sector Oversight Agency should be created through statute, for example, to replace the HLCC ��� but also it should have clear duties so that it does not become a place to have ���chai biscuit��� and then leave. The proposed FSOA is a light but high-level structure, chaired by a regulator (possibly RBI), and drawing staff from existing regulators on a rotational basis. It will force interaction between regulators, and will hopefully encourage much more informal co-ordination structures than the ones at present. The problem with the current system where everything is informal is that we have the illusion on the surface that things are working but the reality concerns me.

Finally, we advocate a system of appraisal of regulators by parliament on a regular basis, along a clear set of parameters/principles devised by the government. Some worry this will increase political interference. To the contrary, we believe this will limit the current system of unlimited responsibility and thus unlimited potential interference after the fact, thus giving regulators more clarity. It will also build more public confidence in the system.